We often hear the terms alpha and beta when talking about investments. These are two different measures that are part of the same equation derived from a linear regression. Don't worry if that sounds too complicated, we'll explain it all in this article.
Key Takeaways
- Alpha and beta are two different parts of an equation used to explain the performance of stocks and investment funds.
- Beta is a measure of volatility relative to a benchmark, such as the S&P 500.
- Alpha is the excess return on an investment after adjusting for market-related volatility and random fluctuations.
- Alpha and beta are both measures used to compare and predict returns.
The Equation
If equations make your eyes glaze over, you can just skip this part. On the other hand, we can go straight to the equation if you know some algebra or ever took a class covering regressions in college. The basic model is given by:
Where:
- y is the performance of the stock or fund.
- a is alpha, which is the excess return of the stock or fund.
- b is beta, which is volatility relative to the benchmark.
- x is the performance of the benchmark, which is often the S&P 500 index.
- u is the residual, which is the unexplained random portion of performance in a given year.
Defining Beta
Beta is a measure of volatility relative to a benchmark, and it's actually easier to talk about beta first. It measures the systematic risk of a security or a portfolio compared to an index like the S&P 500. Many growth stocks would have a beta over 1, probably much higher. A T-bill would have a beta close to zero because its prices hardly move relative to the market as a whole.
Beta is a multiplicative factor. A 2X leveraged S&P 500 ETF has a beta very close to 2 relative to the S&P 500 by design. It goes up or down twice as much as the index in a given period of time. If beta is -2, then the investment moves in the opposite direction of the index by a factor of two. Most investments with negative betas are inverse ETFs or hold Treasury bonds.
What beta also tells you is when risk cannot be diversified away. If you look at the beta of a typical mutual fund, it's essentially telling you how much market risk you're taking.
It's crucial to realize that high or low beta frequently leads to market outperformance. A fund with lots of growth stocks and high beta will usually beat the market during a good year for stocks. Similarly, a conservative fund that holds bonds will have a low beta and typically outperform the S&P 500 during a poor year for the market.
If a stock or fund outperforms the market for a year, it is probably because of beta or random luck rather than alpha.
Defining Alpha
Alpha is the excess return on an investment after adjusting for market-related volatility and random fluctuations. Alpha is one of the five major risk management indicators for mutual funds, stocks, and bonds. In a sense, it tells investors whether an asset has consistently performed better or worse than its beta predicts.
Alpha is also a measure of risk. An alpha of -15 means the investment was far too risky given the return. An alpha of zero suggests that an asset has earned a return commensurate with the risk. Alpha of greater than zero means an investment outperformed, after adjusting for volatility.
When hedge fund managers talk about high alpha, they're usually saying that their managers are good enough to outperform the market. But that raises another important question: when alpha is the "excess" return over an index, what index are you using?
For example, fund managers might brag that their funds generated 13% returns when the S&P returned 11%. But is the S&P an appropriate index to use? The manager might invest in small-cap value stocks. These stocks have higher returns than the S&P 500, according to the Fama and French Three-Factor Model. In this case, a small-cap value index might be a better benchmark than the S&P 500.
There is also a chance that a fund manager just got lucky instead of having true alpha. Suppose a manager outperforms the market by an average of 2% during the first three years of the fund without any extra market-related volatility. In that case, beta equals one, and it might look like alpha is 2%.
However, suppose the fund manager then underperforms the market by 2% over the next three years. It now looks like alpha equals zero. The original appearance of alpha was due to sample size neglect.
Very few investors have true alpha, and it typically takes a decade or more to be sure. Warren Buffett is generally considered to have alpha. Buffett focused on value investing, dividend growth, and growth at a reasonable price (GARP) strategies during his career. A study of Buffett's alpha found that he tended to use leverage with high-quality and low-beta stocks.
The Bottom Line
Alpha and beta are both risk ratios that investors use as tools to compare and predict returns. They're significant numbers to know, but one must check carefully to see how they are calculated.
FAQs
Both alpha and beta are historical measures of past performances. Alpha shows how well (or badly) a stock has performed in comparison to a benchmark index. Beta indicates how volatile a stock's price has been in comparison to the market as a whole.
How do you explain alpha and beta? ›
Alpha and beta are two different parts of an equation used to explain the performance of stocks and investment funds. Beta is a measure of volatility relative to a benchmark, such as the S&P 500. Alpha is the excess return on an investment after adjusting for market-related volatility and random fluctuations.
What is the difference between alpha and beta strategies? ›
Alpha measures an investment's return (aka performance) relative to a benchmark, while beta measures an investment's volatility compared to the overall market. Together, these statistical measurements help investors evaluate the performance of a stock, fund, or investment portfolio.
What is a good alpha for a stock? ›
Generally, a good alpha is one that is greater than zero when adjusted for risk.
Is High beta good or bad? ›
Beta is a concept that measures the expected move in a stock relative to movements in the overall market. A beta greater than 1.0 suggests that the stock is more volatile than the broader market, and a beta less than 1.0 indicates a stock with lower volatility.
Is High alpha good or bad? ›
Anything more than zero is a good alpha; higher the alpha ratio in mutual fund schemes on a consistent basis, higher is the potential of long term returns. Generally, beta of around 1 or less is recommended.
What is the difference between alpha and beta personality? ›
Things You Should Know. Alpha males are fearless trailblazers who love to be in control while beta males are kind, gentle souls who prioritize personal connections. Sigma males are rebellious leaders with lots of life experience while delta males are responsible companions who you want by your side.
What does alpha stand for? ›
As the first letter of the alphabet, Alpha as a Greek numeral came to represent the number 1. Therefore, Alpha, both as a symbol and term, is used to refer to the "first", or "primary", or "principal" (most significant) occurrence or status of a thing.
What does it mean when someone is a beta? ›
As they say, nice guys—and betas—finish last. Beta is a slang insult for or describing a man who is seen as passive, subservient, weak, and effeminate.
What is the relationship between alpha and beta? ›
Relation between α and β:
The common-emitter current gain (β) is the ratio of the transistor's collector current to the transistor's base current, i.e. And the common base DC current gain (α) is a ratio of the transistor's collector current to the transistor's emitter current, i.e.
For instance, in the flexibility dimension, the alpha leader will be direct and authoritative, thereby taking a minimally flexible approach. By contrast, the beta leader will be inquisitive and will collect feedback from employees to reach a consensus on decisions, representing a maximally flexible approach.
What are beta strategies? ›
Smart beta strategies seek to passively follow indices, while also considering alternative weighting schemes such as volatility, liquidity, quality, value, size and momentum. That's because smart beta strategies are implemented like typical index strategies in that the index rules are set and transparent.
What is a bad beta for a stock? ›
Key Takeaways. Beta indicates how volatile a stock's price is in comparison to the overall stock market. A beta greater than 1 indicates a stock's price swings more wildly (i.e., more volatile) than the overall market. A beta of less than 1 indicates that a stock's price is less volatile than the overall market.
What is a good beta to buy a stock? ›
A beta value that is less than 1.0 means that the security is theoretically less volatile than the market. Including this stock in a portfolio makes it less risky than the same portfolio without the stock. For example, utility stocks often have low betas because they tend to move more slowly than market averages.
Which stock has highest alpha? ›
Nifty 50 Top Alpha Stocks
| S.No. | Name | CMP Rs. |
|---|
| 1. | Adani Green | 1793.75 |
| 2. | Adani Enterp. | 3063.35 |
| 3. | Adani Power | 596.90 |
| 4. | Trent | 4168.60 |
23 more rowsRelation between α and β:
The common-emitter current gain (β) is the ratio of the transistor's collector current to the transistor's base current, i.e. And the common base DC current gain (α) is a ratio of the transistor's collector current to the transistor's emitter current, i.e.
Why is it called alpha and beta? ›
“Alpha” was chosen to be first because it's the first letter of the Greek alphabet, and an alpha is the first version of a software program. “Beta” comes next in the Greek alphabet, and it's the next version of the software distributed. If more versions were considered, we'd have gamma, delta and epsilon versions.
What is the difference between alpha and beta biology? ›
The sole chemical difference between alpha and beta glucose is the orientation of the -OH (hydroxyl) and -H (hydrogen) groups on carbon 1. Unlike beta glucose, which has its -OH group attached above the ring, alpha glucose has its -OH group linked below the ring.
